BIS warns Asia central banks about balance sheets

GeoffreyT. Smith

LONDON (MarketWatch) -- The rapid expansion of central bank balance sheets in emerging Asian economies could lead to higher inflation and financial instability in the long run, the Bank for International Settlements said in its quarterly report, published Sunday.

"Serious consideration should also be given to capping and then shrinking the size of central bank balance sheets," the BIS said, adding its familiar recommendation of more flexible foreign exchange rates to slow or stop the accumulation of foreign reserves.

"Greater tolerance of currency appreciation over time could be a key element of a framework to limit further accumulation of foreign assets," the BIS said in a special chapter in the report.

The combined balance sheet of nine central banks in emerging Asia rose nearly six-fold between 2001 and 2011, from $1.1 trillion to $6.4 trillion. During the decade, a raft of countries, most with export-led economic growth models and persistent current account surpluses, stopped their currencies appreciating by building up vast foreign reserves, mainly in dollars.

As a result, the balance sheet of, for example, the Chinese and Malaysian central banks was nearly 50% of gross domestic product by the end of 2011, more than twice as large, proportionately, as that of the U.S. Federal Reserve or the European Central Bank.

The BIS said the central banks in question had largely done a good job of containing inflation, historically the biggest risk associated with balance sheet expansion.

However, it argued that the tools used to do that--such as high reserve requirements and large issuance of central bank paper to absorb excess liquidity--are risky in their own right.

It argued that reserve requirements act as an unofficial tax on banks, encouraging credit growth in less regulated and more opaque unregulated ways--what is known as "shadow banking"--and may threaten financial stability over time.

The BIS also said that some of the central banks it studied have a distorting effect on their own money markets because they are by far the biggest player. As a result, banks are focusing less on market signals as they allocate capital and more on second-guessing an official body whose objectives may not always be clear.

The BIS highlighted problems in how such policies affect local banking systems, saying the accumulation of foreign reserves reduces the amount of money available for domestic lending, and that the focus on keeping exchange rate stability encourages banks to assume greater foreign-exchange risk.

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